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Home , Call option, Derivatives market, Derivative (finance), Financial instrument, Put option

The Role and Importance of the Options as a Unstandardized Financial Derivatives

Aleksandar Dejanovski 1

1MIT University, Skopje, Macedonia

Abstract - The financial derivatives are financial result, this financial doesn’t have to be instruments, that are recently created, and whose main executed from the buyer, but when is, the seller, application is to be used as a tool for managing always have to pay the contracted sum of , or financial derivatives. The most significant financial other financial . The value of the options is derivatives are options, that are mostly used for their derived from the value of , indexes, flexible and non-standard character. Options, and the other financial derivatives, as well, are instruments foreign and futures. These financial that are derived from some other financial instruments are known as “basic assets”. The options instruments, that makes them more complicated from are used for: one hand, and more risky, from the other hand. Their role is very important for the developing the financial • To protect certain or to reduce [1]. system, and generating economic growth. • In the case of buying options - for requiring or The subject of research in this paper is the options as a selling the assets at favorable in unstandardized financial derivatives, and their basic the future. characteristics and usage in developed, and developing • In case of options selling - to making additional countries. The prime goal is to research the importance income. of these derivatives in developing countries, with basic focus in the Republic of Macedonia. The results from The second and the third purposes are from these paper should suggest if the options are crutial for speculative nature, but the first purpose is actually the developing the Macedonian financial markets. the basic purpose of financial derivatives such as options, risk reduction and hedging. Keywords: Financial derivatives, options, hedging, The main difference between the options and call , , position, position. some other financial derivatives is that the holder of the option has the right to decide whether it will be used, ie realized, or not, while the futures, swaps and forwards doesn’t give that right. The other financial 1. Introduction derivatives, both parties are obliged to fulfill the obligations arising from the . Although the Options are financial instruments that primarily option holder (buyer) has the right to leave are used in developed countries and are applied for unrealized option, with signing the contract, he has to reducing unnecessary risk, that exist. The process of pay a certain amount called the premium. Unlike the using a in to reduce the buyer of the option, the seller of the option has no risk in financial theory is known as hedging. The exclusive right. By the signing of the contract the options are specific form of financial derivatives buyer receives the same premium as the price of the because of its popularity and unstandardised form, sold option, but is obliged, in the future, to pay that are used in developed and developing countries, certain amount of money if the option buyer realize as well. Options, as a financial derivatives, are (execute) the option. So we can conclude that the financial instruments that have been derived from seller and buyer of the optional agreement are not in another financial instrument’s value. equal condition. This asymmetry is result to the Options and all financial instruments have their optional contract. Despite the options, buyers and value derived from the value of another financial sellers of futures, forwards and swaps are placed in a instrument. These instruments have a price of symmetrical position with equal rights and execution, date, period of validity, cost of obligations. conversion and other basic elements that together Options are through which a seller with the price of the underlying , affect the value gives a buyer the right, but not the obligation, to buy of the option. The option is a financial derivative that or sell a specified number of shares at a gives the holder the right to realize the same option predetermined price within a set time period. [2] over specific time. It’s up to the user to decide, if he From the definition, we can determinate the basic wants to execute the option or not, and when. So, as a elements of an option agreement:

TEM Journal – Volume 3 / Number 1 / 2014. 81 www.temjournal.com • The basic assets are financial instruments • , or option that gives right to buy the underlying the optional contract. Some basic underlying asset at the cost of execution in assets can be considered stocks, stock indexes, future time. foreign currencies and futures. • Put option, or option that gives right to sell the • Buyer has to pay the the option seller certain underlying asset at the specified price within a amount of funds, known as an option premium, specified time in the future. which can be regarded as the price of the option. Within paying the premium, the buyer has By the second criterion, the options are systematized bought the option and can execute in the future, by the possibility to be realized before the end of the when he decides, while the issuer or seller of the specified period: option gives the buyer the right, in that period or earlier (depending on the type of option) to sell • The European type options doesn’t allow or buy the asset that is subject of the option conversion before the specified day of delivery contract , ie to buy or sell the underlying (basic) ( date), the expiration date specified in asset at a fixed price. the optional contract at the time of signing the • The option that gives the buyer the right to buy same. This feature of the European type reduces any financial assets in future is known as call the liquidity and makes them less option, while the option that gives the buyer the attractive trading instruments. right, or the owner the option to sell the basic • Unlike the European type of options, the asset (as or action) is known as the put American type allowed the option to be option. implemented before the expiry date of the • The options have a period of execution that contract, which increases flexibility and liquidity differ according to the type of the option. In of financial instruments and markets as well. European type of options, the execution is done American type of options is more attractive in exactly certain day in the future, so it is instrument from the European types, because if predetermined and can’t be changed. While the there were some positive trends in the options American type of options, although there is market, the option value would increase in the specific day for execution of the option, it is also future, so the wouldn’t have to wait for to be executed earlier, in a shorter time interval. the expiry date of the contract, and can execute • The cost of executing is a predetermined value ie the option before the selling the option and could price at which the option will be executed in earning money, that can be used for other future. The buyer will execute the option, only if investments. the price of the underlying asset decreases and drops below the price of the option. At that According the third criterion the options can be point, the option would worth more than the categorized, according to the type of underlying underlying assets and the buyer would realize assets: (execute) the option. If the price of the underlying assets should remain equal or • Stock options increase further, it wouldn’t be valuable to • Stock index options execute the option, and the buyer would left it • Future options unexecuted. • Product options • All the features of a particular type (put or call), derived from a particular action are called In the proceeding we are going to pay attention to the specific class options, and all options of a given option payoffs. Buying a call option involves buying class with the same price and the same execution the right to buy the underlying asset in the future at a date of realization are known as a specific series price of execution. The buyer is obliged to pay an of options. optional premium in the hope that the future price of the underlying asset will rise. If the cost of the assets 2. Types and Payment Options grows over the price plus the option premium paid then the buyer will realize (execute) the option, and In theory and practice there are several types of gain some profit, but if the price of the asset options that can be divided according to three decreases, then the investor shouldn’t categories: option, because it is not profitable action, and then According to first criteria, by selling or buying the the overall loss for the buyer will be equal to the underlying assets, there are: premium paid.

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option payoff Figure 1. Long call option payoff [3] Figure 3. Long put option payoff

Selling the call option involves selling the right to Selling a put option involves selling the right to buy the underlying asset in the future. The seller gets sell the underlying asset at a price in future. The the optional premium immediately after signing the profit of the seller is the premium which is agreed by contract and it is his only income that can be contract. As noted, he is obligated to buy the considered for him. He is obligated to sell the underlying asset in the future at a price agreed in the underlying asset to the buyer, or to the end of the optional contract. The sellers expect the future price period (European option) or before the expiry of the of the asset to increase, or to remain the same, so the period (an American call option). The basic buyer would not execute the option, because the expectation of the call option seller is that in the price is already high. The loss of the put option seller future the price of the underlying asset will not may be very large if the asset price falls and the change or decrease, so the buyer would not execute option buyer execute the option, i.e. sell the asset at a the option and the issuer would make a profit. The higher price than the current one. The loss can be profits of the issuer equal to the optional premium, expressed as the difference between the execution but the loss can be large and arises from the price and the price of the asset plus the premium. difference between the current market price of the asset (which is larger than the optional cost) and the cost of executing the option.

Figure 4 short put option payoff [5] Figure 2. Short call option payoff [4] spread options, or CSO presents a special Buying the put option means buying the right to type of credit derivatives or an instrument to protect sell the underlying asset in the future at a certain the from losses in the value of the approved price. The buyer is obliged to pay an optional or offsetting the higher cost of borrowing which premium by signing the agreement in the future is may occur due to changes. For example, expected to decline in the price of the asset to realize the bank may enter into an agreement with a options profits. The investor’s loss is equal to the optional dealer that guarantees payment of the loan in the premium, while profits can be large and represents event of a reduction of its value, or due to the difference between the execution price and the dysfunction of the loan. If the credit event occurs, the current market price of the asset plus the amount of bank will use the option and the dealer will pay loss the premium. to the bank. The process of using this instrument can be seen in the chart below. These options are used for limiting the loan approval costs in case of a reduction of the credit rating of the bank. When the bank plans to issue long-term bonds, but is afraid that prior to their issuance, a reduction in the credit rating can happen, which would generate future payment of higher interest rates, the bank can

TEM Journal – Volume 3 / Number 1 / 2014. 83 www.temjournal.com Figure 5. Scheme of credit options [6] buy credit swap option , which would be related to zone “out the money”, it is less likely that in the the difference between interest on securities issued future would be “in the money”. So, the options that by the bank to possibly worsening credit rating and are deep out-of-the-money area have lower value the that dominate the market, then the options that are not as deep out-of-the- similar to those that the bank wants to execute. If, the money zone, and price performance is closer to the bank credit rating declines the interest rates would price action. increase, then this option will be used by the bank and therefore would receive payment for the value of Time-to-maturity. Generally speaking, the deteriorating ratings, on the other hand, If the credit longer the time of maturity the valuable the options. rating of the bonds grow, the option is not activated, If the maturity is longer, it is more likely that the so the premium would be the only cost for the bank. option should enter the” in the money zone” and the value increases. European type options are more 3. Factors that Affect the Price of Options valuable as time to maturity increases, because they can be exercised only on a certain predetermined day. Which means that, if the option to enters in-the- There are several factors that affect the price of the money zone before the time to maturity, the options: [7]. European owner, does not have the right to execute it. So the European option may become worthless on • The stock price the day to maturity, although earlier had been in-the- • The execution price money zone. • Time to maturity • The Volatility measures the magnitude of the change • The policy in the price of the stock for a certain period of time. • The interest rate Volatility, as a measure is showing the uncertainty of the future movements in the price of the stock. As the All these factors have influence on the option volatility increases, the likelihood of price action to price that is constantly changing through time. The change the future, increases, as well, at the same financial managers need to perform detailed analyze time. If the stock has more volatility, it means that its and research if they want to qualify the risk from the price should be change in the future, more often ie particular optional strategy. would oscillate a lot. This means, that the option of such action would have a higher probability to enter The stock price is the first and basic factor in-the-money zone in comparison with a options that determining the value of options .The relation have low volatility. Also, the option of an oscillating between the execution option price and the stock stock, would have a higher intrinsic value of the price over some time period presents the option option of an less oscillating stock, because the price profit, while the total loss is limited for the amount of of the stock could easily enter deep in-the-money the premium. If the stock price rises, then the call zone achieving enormous gains for the owner. On the option would become more valuable, but if the stock other hand, the loss is limited to the premium paid. price falls, the put options would become more valuable. . When a company pays dividends , it automatically means that the value of the shares is The execution price as a factor in determining reduced. Thus, if the expected payment of dividends the value of the options is directly related to the first is unannounced by a particular company, it would factor, the stock price. As we know, the intrinsic increase the put premiums and would reduce value of the option is a function between stock premiums the call options premiums for shares of and option prices. The option price is higher if there that company. But, since most dividends are is in-the-money zone, and it has more internal announced and are familiar with all entities, then the valuable asset. If some option enters deep into the most options traders, have already calculated the

84 TEM Journal – Volume 3 / Number 1 / 2014. www.temjournal.com amount of the dividend premium price. In such cases, margins for vendors or subscribers. The term the dividends do not represent significant role in refers to the , that is required determining the price of options. from the debtor, in order to secure the option, as a guarantee for fulfillment of the obligation in Interest rates. The impact of the interest rates the future. on the price of the option is quite uncertain. Yet interest rates affect the cost of the options, increasing Unlike the OTC market, the organized trading or reducing the of the costs of the market is typically more standardized, with existence execution. With the increase in the interest rates in of a special supervisory authorities and compliance the economy, the value of put option is reducing, so with certain rules in the form of: it comes to reducing the present value of the cost of execution (X - S) and also increases the value of the • Minimal requirements for option trading. The call option, as result of the reduced present value of determinates the rules and the the cost of execution (S – X ). minimal criteria for every instrument that could All previous elements can be summarized in the be traded in the option exchange market. following table. • The size of the contract. The standard optional contract contains 100 options. So every purchase Table 1.Basic factors affecting the price of options [8]. of a contract would automatically mean buying 100 shares in the future based on 100 options. Factor Call option Put option There are specific cases, when the stock splits. price price • The execution price. This category is Stock price + - standardized and specified by the Exchange Execution price - + Time to maturity + + itself. The exchange specifies exactly how much Volatility + + can be the exchange price of certain options. Dividends - + The determination of the price is carried out by a Interest rates + - professional experts, which among other obligations shall determine the price that will provide continuous, and uninterrupted trading. 4. The Structure of the Option Markts in the • In 1993, CBOE introduces the FLEX (flexible) Developed Countries options, as new, flexible options, which represent a major blow to the standardized stock The options market structure includes all markets. They may not have any cost of institutions, elements and entities who need for the execution, which is not directly determined by market features to work continuously. As already the market. Because of the flexibility, this mentioned, the options are mostly traded on the options become commonly used by more (Over the counter) OTC markets, however, the common users in the developed markets. trading can take place on a specially organized • the date of execution (leakage) of the contract. markets for trading options, as well. The developed Unlike the OTC market, where the date of countries options, primarily via OTC markets. execution is determined as a result of the needs of the buyer and seller, the organized manner of The basi features of the OTC market are: [9] trading, every action is categorized in any particular round of execution. There are three • The options, that are traded in this market are rounds of performance as follows: tailored to the requirements of users in terms of a. January April, July and October amounts and maturity, b Februar May, August and November • The options premiums are higher than those of v. Mart, June, September and December. an organized option markets. This difference is due to the nature of the options that are traded on The execution of the contracts is specified in the the OTC market. current month, next month or the next month in the • Options traded on the OTC market are mainly second part of the circle of execution since the stock from the European type, and they do not have the is purchased. For example - a specific stock that is flexibility characteristics of American type listed in the January round of execution, should have options. certain options with dates of execution in July, • The absence of a secondary options market. October and January. • The actual trading on the OTC market requires the existence and keeping records of the option • position limits and the limits of performance. Position limits define the maximum number of

TEM Journal – Volume 3 / Number 1 / 2014. 85 www.temjournal.com options that some may keep on one financial derivative instrument is such an instrument side of the market. whose price is directly or indirectly dependents from The limits of performance show the maximum the price of the securities, , foreign number of options that can be executed in any exchange, stock exchange indices or interest rates five consecutive days by individuals or group of that do not verify the , which is derived from. individuals. [10]. The Law on Securities defines the futures and options as standard financial derivatives. The purpose for using the positional limits of Standardized instruments are those instruments that execution is perceived in the prevention from certain are traded in an organized market and which give entities that have a large market , and therefore holders the same rights. The form and structure of big impact on the price of options. standardized instruments is strictly regulated by the In terms of market structure, we distinguish several Commission for Securities. participants in the trading of options on organized Macedonian law, as financial derivatives, defines markets: only the futures and options. According the same law, since 2005, futures are standardized contracts • The first type are the market makers. When a for future sales of pre-determined date of securities, subject wants to buy or sell a particular option, foreign exchange, commodities, indices or interest and no other is interested to buy or sell the same rates, which one party undertakes to carry out the option, then enter market makers enters and agreed handover of and the other party is complete the transaction. Market makers ensure obliged to pay the pre-agreed price. and guarantee to the subjects, that their According to the same law, article 2, paragraph 9, the transactions will always be realized and thus options are standardized contracts for future purchase they increases the liquidity of the option markets. or sale of securities, foreign currencies, commodities, is an entrepreneur and as such, to stock exchange indices or interest rates, in which one earn, it has to buy options at a lower price and party has the right but not the obligation to buy or sell at a higher, using it at BID-ASK spread. sell the underlying, at a previously agreed price, • The second type of participants are the brokers, every day until the end of the agreed period, the other who execute orders on specific subjects in the party is obliged, at the request of the first organized options markets. In the organized unconditionally surrender or undertake to pay the trading options market is not allowed for all the agreed subject to the option. interested subjects to attend the trading, because Although a legal framework is set, the trading with they are obliged to appoint a broker, that should the financial derivatives is still under development in represent them. The brokers work on behalf of the country [11]. The introduction of the derivatives clients and as such, earn commission for their in Macedonia would have more effects on the work. They have expert knowledge that shares economy as a whole, as well. It would reduce the with the subjects and strive to obtain the most overall risk in the economy, would further increase favorable price for their clients, as well. There the confidence of foreign investors and would can be found an combined form the previous two modernize the Macedonian , creating types, called DPMs (designated primary market economic growth. makers) or separated market markers. • The third type of traders in the organized option In Macedonia, it is necessary the following factors to market are the officials or OBO (order book be fulfilled in order to enable the financial officials). They receive all the orders and classify derivatives trading: them. Then when a change in the trading situation occur, and the option price falls below • Development of the financial markets, the ASK price, it would be logical that the • European Union entry, and adoption of the Market makers should exit the trading (no gain). European legislation, So then the OBO should enter the market, and • regime change, in order to create liquidity. introduce foreign exchange swaps, • Development of the principles and mechanisms 5. The Financial n RM of the process of risk , • Maintenance of special courses and seminars for While in the Republic of Macedonia there is an the usage of these instruments, established legal framework the foundations for the • Establishing an official financial derivatives development of the financial derivatives and laid, it market, is still unexecuted and undeveloped. According to • Creating an unofficial market for the financial article number 2, paragraph 7 from the securities law, derivatives, over the counter market.

86 TEM Journal – Volume 3 / Number 1 / 2014. www.temjournal.com 6. Conclusions [5]. Smithson, C. W. (1998). Managing . McGraw-Hill. The recent global financial crisis, had further increased the uncertainties of the financial markets, [6]. Tome Nenovski, Evica Delovska Jolevska. (2012). which significantly had reduced the trading of these "Money and Banking", University American College Skopje, page 192. instruments. The argument is supported by the fact that the financial derivatives were the fundamental [7]. John [C.] Hull. (1997). Options, futures and other causes for the crisis. derivatives. Prentice-Hall International., 120 – 124.

[8]. George M. Jabbour – “The option handbook”, References (2004).

[1]. Whaley, R. E. (2007). Derivatives: markets, [9]. Mehta, D., & Fung, H. G. (2008). International bank management. John Wiley & Sons. valuation, and (Vol. 345). John Wiley & Sons. [10]. Law on Securities of the Republic of Macedonia - [2]. http://www.nasdaq.com/investing/options- Official Journal no.95. (2005). guide/definition-of-options.aspx [11]. Donald P.Delves, (2004). ” Stock Options And The [3]. Fontanills, G. A. (2005). The options course. High New Rules Of Corporate Accountability”, McGraw- Profit & Low Stress Trading Methods, 90. Hill.

[4]. Fontanills, G. A. (2005). The options course. High Profit & Low Stress Trading Methods, 96. Corresponding author: Aleksandar Dejanovski Institution: MIT University, Skopje, Macedonia E-mail: [email protected]

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